As per our last post in Valuation Series (Valuation Post 7: Drivers of Business valuation Basic Framework Part 2) we understood that ROIC, Reinvestment rate, Cost of Capital, Growth rate, and length of growth period as some of the key drivers of Valuation multiples.
In this post we will break some of the assumptions of the basic framework and create various scenarios to understand which situation leads to a fundamentally higher Multiples like P/E or P/B.
You might have always heard that Growth increases valuation right?
So now let us understand that "growth for the sake of growth" does not always leads to an increase in valuations of the company.
In Valuations Post 6 we assumed that company was paying full dividend and wasn't reinvesting in business due to which it was not growing but here in this case we have assumed this business is growing at 5%. Let's see the impact on valuations:
First some math on how the numbers in the above image have been derived:
NOPAT of Year 1 = Capital at beginning of Year 1 * ROIC = 100 * 10% = 10
FCFF = NOPAT - Re-investments (NOPAT of Year 1 * Reinvestment rate) = 10 - 5 (10*50%) = 5
Ending Capital 1 / Beginning Capital 2nd year = Beginning Capital of Year 1 + Re investments = 100 + 5 = 105
NOPAT of Year 2 = Capital of Year 1 * ROIC = 105 * 50% = 10.5 (and process goes on)
Similarly we have assumed that the company will be able to sustain a ROIC of 10% and Have opportunity size big enough to re-invest 50% of their earning i.e. reinvestment rate of 50% perpetually.
Through above assumptions we could calculate terminal Value at the end of 5th Year
TV of Year 5 = FCFF of Year 6 / WACC - g
Discounting all the cash flows along with terminal value at the point zero (today) gives us the fair value of the company as Rs. 52 with P/E and P/B as 5.2 and 0.52 respectively.
ALERT: Value of the company is decreasing despite the fact that the company is growing 😀😀😀😀😀
It is because the WACC/Cost of Capital of the company is higher than the Return generated by the business.
For companies having WACC > ROIC it's better to stop growing for some period and focus on increasing ROIC or reducing WACC otherwise the value of the company will instead be destroyed rather than enhanced.
The faster the companies grows with this structure the faster it destroys value for shareholders.
Note: Please read Valuation Post 9: Drivers of Business valuation framework Part 4 (ROIC Impact) for further drivers.